High-yield bond activity in Europe was remarkably strong this year, given the backdrop of a global pandemic for the last 10 months. Indeed, 2020 has recorded the second largest full-year volume since LCD's records began in 2006, with three months registering volumes of €13 billion or more — a feat not previously witnessed in the market during a calendar year.

Issuance was rather lumpy, with the strongest start to a year ever suddenly knocked off course by the onset of COVID-19, leading to three months of very little high-yield bond supply (just 10 bonds priced in March to May, while January alone hosted almost three times as many bonds). The June-October period was electric for the market however, with four months during this period (excluding the holiday-impacted month of August, which drew a blank for issuance) all setting double-digit volume totals (€B). That is also a record run for the European high-yield market.

Amid such heavy supply, new-issue yields remained close to record lows and that helped fuel a spate of opportunistic issuance, which is a theme set to continue in 2021. Indeed, refinancings of all kinds accounted for almost two-thirds of the total high-yield volume, which is ahead of the 52% average share on that measure for the 2006-2019 period. In contrast, 20% of the volume was used to support M&A or LBO situations, versus an average share of 28% for the aforementioned period, and it is this part of the market that participants hope will pick up in 2021.

"The vaccine announcement opened the floodgates and technicals remain extremely positive, as is central bank rhetoric," says Carlo Fontana, head of global syndicate at UniCredit Bank. "This led to a strong rally in credit markets, and Q1 [2021] could be even stronger. Some of the deals in the last month have highlighted how supportive the market has been, and this ought to continue, enabling companies that need liquidity to issue high-yield or loans."

Against this backdrop, market participants say the following drivers will be important for 2021.

Drivers to the upside:
COVID-19 vaccine. News in November of three effective vaccines for the coronavirus arguably proved the biggest driver for risk-on sentiment in the latter part of this year. Coming into that month, there were concerns that companies would not be able to bridge the revenue and financing gap until social distancing and lockdowns stopped. While many raised roughly six months of liquidity at the start of the crisis, this was about to have been burnt through, leaving a stream of companies in a precarious position. Now though, there is little doubt that the capital markets are fully open to most businesses. Moreover, the end of the year was characterized by a "dash for trash" as fund managers piled into as many COVID-19-impacted names as they could. Entering 2021, there is potential for the compression trade to continue, completing a remarkable turnaround whereby the least-loved credits have become the most sought-after.

Technicals. The other contender for biggest driver of risk-on this year, and without question the key plank of support for financial markets since the COVID-19 crisis hit, has been the unprecedented level of central bank and government stimulus, which has boosted demand. This is set to continue in 2021, with many in the market commenting that ECB stimulus measures will remain the key source of support. This dynamic will also lead to an ongoing hunt for yield, money flowing into high-yield funds, and yields on the lower rungs of the ratings ladder being dragged lower. This has been the case for many years now, but before the crisis markets were having to contend with being weaned off central bank stimulus measures, whereas now these looks like they are here to stay for a considerable time to come. "Unless you are worried about inflation, central bank support is not going anywhere," says Ben Pakenham, head of European high yield and global loans at Aberdeen Standard Investments. "Markets only care about relatives, not absolutes. This ought to ensure that high-yield is well supported by inflows."

Need for liquidity. While a vaccine is on the way, it will still take many months before life can fully return to normal. That means companies still need to contend with reduced revenue generation in the months to come, and many will need to bridge the gap. While companies in Europe leant heavily on relationship bank lending and government handouts in the early throes of the COVID-19 crisis, U.S. companies flocked to the bond market, leading to an explosion of issuance. No one is forecasting similar levels of supply for Europe in 2021, but there are hopes that more companies will turn to the capital markets this time. Certainly, risk appetite is much higher at this stage of the crisis, and the market is open to more challenged credits, as has been demonstrated numerous times in the last few months — and even in some instances before the vaccine news.

"We have proven this year that deals can get done for tougher credits in the middle of COVID-19," comments Todd Rothman, managing director, high yield and leveraged loan capital markets at J.P. Morgan. "There will continue to be a lot of demand for issuers that have a compelling credit story, more than sufficient liquidity, and where investors feel like they are being well compensated for the risk. We expect a lot of tightly priced double-B refinancings too, so the hunt for yield will have to continue down the ratings spectrum."

Payback. While companies rushed to draw down on their revolving credit facilities (RCFs), or took on more debt elsewhere to get through the first lockdown, a number that fared better than they thought might now look to term-out the RCF drawings and other debt via the high-yield bond market. Repaying RCFs has already been a common use of proceeds for high-yield borrowers in recent months, and this trend is expected to continue in 2021.

More LBO/M&A activity. With economic growth expected to be subdued, companies cannot rely on organic growth, and shareholders will therefore likely look to dispose of non-core assets. This dynamic may intensify too, as challenged companies also look to repay debt and need to raise funds to do so. All this should in turn lead to greater amounts of corporate M&A activity, as well as more public-to-private deals for private equity players. "A lot of supply this year has been vanilla double-Bs, but we are confident that M&A will be a bigger feature of the market next year," comments Diarmuid Toomey, head of strategic capital markets at Deutsche Bank. "The challenge for next year is equity markets keeping valuations high. We might see a barbell approach to M&A where best in class assets sell for mid- to high-teens multiples, and on the other side COVID-19-impacted sectors or those with sectoral headwinds transact at materially more modest multiples."

Refinancings. While such deals do little for net supply, the low yield environment will lead more companies to refinance their bonds. Bankers admit that in the last few months, the number of cases where a company could take out the bonds early and still be in the money is growing, and 2023 maturities will be in play for a refinancing next year. Moreover, Saul Doctor at J.P. Morgan wrote in the bank's 2021 outlook piece in November: "By our figures, €110 billion of bonds are either callable right now, or enter their call window next year. Of this, only €30 billion is currently priced assuming the call will be exercised, but it takes very little incremental tightening for workout dates to shorten en masse, especially since the average coupon for this cohort of bonds is relatively high, at 4.8%."

Drivers to the downside:
Good news is all priced in. "The recent news on the COVID-19 vaccines has been most welcome and the bond markets, like the equity markets, have reacted very positively," comments Stephen Llewellyn, managing director, debt advisory at Rothschild & Co. "In the bond markets we have seen companies access very tight pricing levels based on the new outlook — levels that would have been unobtainable a few weeks earlier. How long can it last? It's hard to see how much more support the markets can get following the vaccine news, the US election outcome and continued central bank support. Is the good news all priced in? Is there increased downside risk? Time will tell next year. Markets are likely to be sensitive to headline news of disappointment — if the rollout and implementation of the vaccines doesn’t go as planned, if Brexit becomes an issue, or if governments struggle to shepherd the economic recovery. There is a lot of potential for bumps in the road ahead, and consequential market volatility. Whilst it is difficult to see anything changing sentiment in the near term, we continue to advise clients who need to access the bond markets next year to be ready to hit available windows opportunistically, starting in January."

Rising leverage. While this is unlikely to derail the market in 2021, fund managers admit they are concerned by how much more debt companies will be taking on to get them through all the lockdowns and social distancing measures. "Leverage has risen for the overall market and certain sectors, most notably leisure and retail, so we need to see earnings catch up with valuations post the most recent rally," says Azhar Hussain, head of global credit at Royal London Asset Management.

Higher default rate. In November, S&P Global Ratings commented: "We expect the European trailing-12-month speculative-grade corporate default rate to rise to 8% by September 2021 from 4.3% in September 2020. To reach this baseline forecast, 58 speculative-grade companies would need to default." Should the forecast be correct, this will be the highest default rate since 2010. The flipside is that default rate forecasts differ markedly (see below), while as buysiders have commented, if they had bought everything this year at appropriate weightings, the winners would have overpowered the losers.

Macro data. While economies are expected to return to growth, global growth is still likely to be soft in 2021. Moreover, as schemes to support employment roll off, unemployment is likely to spike, meaning less consumer spending, and greater stress on economies and corporate balance sheets.

Supply forecasts
There is a wide spectrum of European high-yield supply forecasts from bank research reports, from BNP Paribas predicting €47 billion of gross supply, to J.P. Morgan's projection of €120 billion gross supply, and €40 billion net supply. In between lie forecasts from ING at €50-€60 billion, UniCredit at €60 billion, and Morgan Stanley at €70 billion.

Default rate forecasts
S&P Global Ratings forecasts a near doubling in European corporate credit defaults next year, to 8%. Fitch in November lowered its forecast to 3.6% in 2020 and 5% in 2021, versus previous expectations of 4.5% and 7.9%, respectively. Bank research forecasts are quite varied for 2021: J.P. Morgan forecasts a default rate of just 2%, with Morgan Stanley forecasting 4%, ING 4%-5%, BNP Paribas and UniCredit 6%, and Citi 6.5%.

Return forecasts
Forecasts for European high-yield bond returns in 2021 are broadly shaking out in a 3%-5% context, with ING at 3%-4%, BNP Paribas at 3.1%, Morgan Stanley and Citi at 4.8%, and J.P. Morgan at 5%. Spread targets range between 260-350 basis points, with a number of fund managers forecasting spreads will tighten to 300 bps.